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Volatility Indexes: VIX and RUT

Interesting story in today’s Wall Street Journal online.

Most people are familiar with the VIX, the CBOE Volatility Index. It uses options prices to measure the expected volatility of the S&P 500 index. A lesser known index is the RVX, the CBOE Russell 2000 Volatility Index. This uses the exact same formula as the VIX, but applies it to the Russell 2000′s stocks.

As you might imagine, the RVX has historically run higher than the VIX, given that it measures the expected volatility of an inherently more volatile small-cap stock index. According to Russell Investments, the “premium,” or the difference between the two indexes, has historically been around 29%. But in 2014, a year that was at first a wild ride for small-caps, and then a wild ride for everyone, the relationship between the two has been both historically wide, and historically narrow.

Read the whole story at the WSJ site

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Volatility and News

Although I am a believer in using options to hedge positions and reduce list, there is no doubt that there are many speculators who use options.

The purpose of today’s post is to warn those speculators about a dangerous trap — one that can be avoided.

News Pending

When a news release is pending, option volume increases because the news may result in a gap opening for the stock price (when the news is better or worse than expected). That is when option buyers make good money — assuming that they got the direction right.

However, there is much more to trading options under these circumstances than the novice trader can anticipate. That option volume pushes prices higher and you cannot pay whatever price is asked when buying options. At least you cannot do that and expect to succeed.

Read more about this scenario at my site.

The discussion continues with a description of how implied volatility is crushed once the news is released. If you are not familiar with the concept that the price of options in the market place is very dependent on implied volatility, take a look here and here.

One method for significantly reducing the cost of playing this game is to trade call or put spreads instead of buying individual options.

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Bulls ‘n Bears. Goldman Sachs vs. Google

Yesterday, after the close, there were two important news events.  One was bullish and the other bearish.  

The Bullish news:  The SEC, in a decision that is beyond my comprehension, accepted a bribe from allowed Goldman Sachs to settle the case pending against it for the amazingly low price of $550 million.  Does anyone at the SEC understand how many billions of dollars – cash that once belonged to the American taxpayer – was handed to Goldman?  Is there no sense of justice at the SEC?  Is there no sense of decency?

Considering only the settlement with AIG – in which they were paid 100 cents on the dollar for paper worth less than half that amount – makes the SEC settlement look trivial in comparison.  I guess that's because it is trivial. 

This is an amazing coup for the company, and the stock has moved significantly higher in after hours trading, 

Had they been convicted, there is no telling what would have happened.  Surely their chief guy, Lloyd Blankfein would have lost his job.  Now, he is absolved.  Goldman Sachs, the poster company of bad behavior suffers no punishment.  No punishment.  For mere pocket change that get to go on as before.  If convicted, they could have been forced out of business. 

And now there is no admission of wrongdoing.  It's a mockery of fair play.  It's true, the banks own the government.  I thought they only owned Congress.  How naive of me.  They own the SEC and probably the White House as well.

This result from a Democratic administration is incomprehensible.  Even under George W Bush the punishment would have been larger.  Perhaps a round number – one billion dollars – just to make the public believe it was a severe punishment.  This time the SEC didn't even pretend to seek justice.  These people are idiots. 

I've said it before and I'll say it again.  The SEC has too many ignorant lawyers.  It needs people who trade for a living and perhaps some intelligent civilians.  This settlement is a joke.

The bearish news is that Google's earning announcement disappointed Wall Street.  The stock was down sharply in after hours trading.

It will be interesting to see if either of these stocks leads the market in a significant move today, expiration Friday.


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Option Volume Continues to Set Records

Data collected from the OCC (Options Clearing Corporation) show that options trading continues to attract increasing interest.  The recent growth rate has been spectacular, except for last year, when the a new annual record barely exceeded the previous year's record.

Below is a chart of annual options (not futures options) volume dating from the opening of the CBOE in 1973.


New records are anticipated for this year.  In fact, through the end of May, volume in equity options is more than 11% ahead of last year's record pace, while index option volume has increased by a remarkable 36%.

May 2010 was the most active month on record when volume for a single month passed 400,000,000 for the first time.  Helping that record total was the single day record of more than 30.8 million contracts, set on May 6 – the date of the 'flash crash.'

There are a great may players in the arena, but each of us can carve out his/her own little niche.

Good trading.


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Can You Beat the Market? Part V. Collars Outperform Buy and Hold

Parts: one, two, three, four

University of Massachusetts Professor Schneeweis and doctoral student Szado conducted a study, sponsored in part by the Options Industry Council (OIC).  The results are first being announced today, 9/23/2009, in a paper entitled: "Loosening Your Collar: Alternative Implementations of QQQ Collars."

Using 10 years of data, the study compared the performance of QQQQ, the PowerShares exchange traded fund when collared and when unhedged (owning QQQQ only, with no options).  As with the CBOE S&P 500 CLL 95-100 Collar Index, this study involved the purchase of 6-month puts and the consecutive sale of one-month call options. This time both the puts and calls were 2% OTM when traded.

[NOTE:  If the same nomenclature were used for this collar as for the CBOE collar, it would be called the OIC PowerShares 100, 98-102 Collar Index].

The study included two different collars: passive (with a set of fixed rules) and active (the rules vary according to changing economic conditions).

The study shows that the collared QQQQ portfolio significantly outperformed a portfolio that simply owned QQQQ from April 1999 through May 2009.  And if that's not enough of an eye-opener, risk was reduced by 65% over the 122 month study.

These results are spectacular, especially when compared with the performance of the CLL 95-110 Collar Index.  I'll comment on that later, but for now, let's concentrate on the findings.


Author's Conclusions

The 6-month put purchase is better than buying either one- or 3-month puts.

Active collar more effective than passive.  But, this is not the place to be concerned with the active collar.  The original paper can be accessed for that information.  UPDATED:  link to that paper.

The authors state that the collar was less effective during the steady up years of 2002 to 2007.  That's as expected.


My comments:

The graph says it all.  The QQQQ got hammered during the bursting of the technology bubble, and that's understandable because QQQQ consists of the 100 largest capitalized, non-financial stocks that trade in the NASDAQ market.  That means this ETF was loaded with technology stocks.

But, something bothers me – and I'm publishing this post before discovering the answer.  Collars are slightly bullish strategies. If you recall from previous discussions, a collar is equivalent to selling a put spread.  These positions are protected against large losses, but how did the collared QQQQ increase in value as the underlying asset was plunging in 2001? 

Is it possible that the premium collected by selling the call was so much higher than the premium paid for the put that it offset losses in the decline of the ETF?  That's just doesn't sound reasonable.  When markets are falling, IV is high, but is skewed so that lower strike prices (the puts bought) is higher than that of higher strike prices (the calls sold).

The only way I can see the collars increasing in value occurs if the strategy is not a true collar but includes more than one put per 100 shares of QQQQ.  Yet, the collar in this paper is defined as one put and one call per each 100 share.  I'll go through the details when available, and report back.  But right now, I find these results very unusual.

Addendum @ 6 minutes later.  Apparently when puts were significantly ITM, there was no longer any downside risk.  Thus, the sale of 2% OTM call options resulted in a profit month after month, as the calls expired worthless in a declining market.  These feels 'wrong' to me.  It's essentially selling (almost) naked calls.  Who would do that in the real world?


These results are very unexpected.  The normal expectation for collars is that they will do an excellent job and protect your portfolio when the market declines.  But, to gain the benefits of that downside protection, the collar owner must accept a limit on upside profits.

And that's the problem.  During the  years of this study, the market was down.  The annualized return for QQQQ over the 122 months of this study is -3.57%, and that's a significant decline.  In other words, there was no upside to sacrifice.  But there was plenty of downside – specifically the bursting of the technology bubble in 2000 – 2001 and the 2008- early 2009 bear market.  Under these conditions, collars always perform well.

Don't misunderstand.  As someone who believes strongly that millions of individual investors should seriously consider using collars on all, or part, of their holdings, I like the results of this study.  But I have no plans to use it out of context.  I want to see how this strategy worked from 1995 through 1998 and May 2009 through the present time.  I want to see the data for this strategy at its worst, not only at its best.  Then we would all be able to see just how well collars perform when compared with buy and hold.  I know this study was performed in academia, and that the numbers can be trusted, but I wonder whether the time period chosen was cherry-picked to produce these outstanding results.  More data please.

From the performance of the CLL 95-110 Collar index (see part IV), we can see severe underperformance for the collar strategy in the most bullish years.  Yet, collars were very valuable during bear markets.  Overall, the performance of this specific collar was disappointing. 

But, in defense of collars, the CBOE produced a collar index that is not as valuable as they might have chosen.  Writing call options that are 10% OTM may be suitable to the bullish investor, but to someone who wants to use collars for both capital gains and protection, I believe the more useful Index is the 95-100 CLL Index, which includes the sale of ATM calls.  I urge the CBOE to publish the CBOE S&P 500 95-100 collar index, which would allow a direct comparison with its BXM (Buy-Write Index).  

There is a lot of data, but it's costly and time consuming to put it all together.  And there are so many possible collars that it's difficult to know which to produce.  But I would love to see the CBOE continue to produce indexes that pull all the data together.  And I'm encouraged that the OIC took part in this study, and I encourage them to support additional studies.

Bottom Line: This paper is very welcome and shows that collars are not always too expensive to pay for themselves and are capable of producing market out-performing returns.  I just wish we had more data.


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Surfing the Internet. You Never Know What’s Out There?

Following one link to another, I found my self visiting, where I found this question:

"If you have small amounts of cash is it better to use it on penny stocks or options?"

I recognize that there are many people who have not yet learned anything about investing.  Many years ago, I spent a good deal of time in libraries and bookstores in an attempt to understand something about investing – before using real money.  I had seen my father buy mutual funds, to the benefit of his broker. [Hey, Tom Guella, are you still out there??]  And, not knowing any better, when I was still in school, I also bought some funds.

But times have changed and the Internet opens up a world of information.  I always find it sad when someone wants to get started (geez, I hope this questioner is first getting started), and is on a bad track.

Buying options or buying penny stocks.  Wow.  Neither is a good choice, especially when the investor doesn't have much cash.  Best is to begin a savings program until you have learned more about investing.

I extracted the following from a Boston Globe article by
Jonathan Stempel and Lilla Zuill (Aug 13, 2009).

"Warren Buffett's Berkshire Hathaway  underestimated the risks of falling stock prices to its billions of dollars of derivatives bets…

The derivatives contracts are tied to four equity indexes in the United
States, Europe and Japan, and are a big reason Berkshire's earnings
fell for six straight quarters. That string ended in the April-to-June
period as stocks rebounded…

Berkshire's Chief Financial Officer Marc Hamburg
told the SEC that last year's 30 percent to 45 percent declines in the
equity indexes 'are in excess of our volatility inputs.'

Buffett expects the contracts to be profitable and can invest upfront
premiums as he wishes. This is one reason the world's second-richest
person believes the contracts are unlike derivatives that are
"financial weapons of mass destruction."

Yes, the market was more volatile than pretty much anyone (Nouriel Roubini, excluded) could have anticipated, even Buffett. 


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Using Options to Play Earnings News

Last Thursday (4/16/2009) GOOG announced it's  quarterly earnings after the market closed for the day.  Thus, anyone who wanted to make a winning trade by buying options before the news was announced, had to buy those call options (or puts) prior to Thursday's close.

Many investors did just that – as they do when companies announce big news.  That news is most often earnings, but the options of biotechnology companies draw a great deal of attention just before the FDA (or the company) announces news of a drug trial.

Establishing an option position prior to a big new release is a common tactic among option traders.  And it may seem that this is an obvious thing to do.  After all, the news may be unexpected and the stock can easily undergo a large upside or downside move.  And if that happens, you want to own option positions because they have positive gamma.  The simplest way to do that is to buy puts, calls, or both (straddles or strangles).

Sounds like easy money, doesn't it?  Rest assured that it's not.  The major reason that it's not easy money is because you are not the only investor who thinks that buying these options is a smart move. Many traders think that way.  As a consequence, the options of those companies are very actively traded in the days leading up to the news – but the highest volume occurs towards the end of the day – just before news is being released.

When there are many option buyers, you know what happens to the price (premium) of those options, don't you?  Sure you do.  They move higher.  And higher.  Astute traders understand that there's a reasonable price to pay for pre-news release options, and trade accordingly.  They may buy or sell options, depending on the price,  and that price is measured by the option's implied volatility (IV). 

Sometimes the buyers are so determined to own options that they essentially pay any price that's asked of them.  They believe that all options are reasonably priced and if the stock doesn't make the big move they anticipate, they'll be able to unload those options the next day and incur a tiny loss.  And if the stock performs as hoped, they see many dollar bills in their future.  The problem is that they are often wrong on both counts.  If nothing happens, the loses are substantial and too often the gains just aren't there.

This is a trap for less experienced traders, and the purpose of this post is to warn you that buying options before news is not the simple game it appears to be.  It's very risky.  Yes, there is the potential for a big reward, but most of the time the price paid for an option is so high that profits, if any, are far less than the option buyer thought they would be.

If you want to know why, just look at the situation from the point of view of the people who sell most of those options to the hordes of buyers: the market makers.  You make a market in the options and buyers arrive.  You sell some.  Next you sell more.  

OK, you're not stupid, you raise prices, hoping to attract some sellers.  You continue to sell more options – both puts and calls.  You don't want to build a risky position, and you want to hedge the options you are selling.  You need some positive vega and gamma.  The only way to accomplish that is to buy options.  So you raise prices again.  You discover that nothings stops these buyers.  sometimes price move high enough to attract more experienced investors who enter spread orders, relieving the buying pressure for a short time.  Often that helps and an equilibrium is reached.  Buyers and sellers nullify each other and the prices no longer move higher.  But on occasion, the price does not matter, and buyers continue to submit buy orders.   To make a long story short, by the end of the day, prices are very high.

Next morning, the news has been released.  The stock may be substantially higher or lower.   Perhaps the news had little effect on the stock price.  But, one thing is certain – all the option buyers from yesterday (and earlier) want to sell their options.  Some are happy that the stock moved in their direction and hope to nail a very nice profit.  Others were wrong and want to get out before the option becomes worthless.  

Bottom line: lots of sellers and few buyers.  Guess what happens to the implied volatility, and thus, the price of those options.  Pretty easy to guess.  Prices move lower.  And sometimes, even investors who correctly guessed in which direction the stock was going to move are shocked to discover that they lost money.  

So how did GOOG turn out?  The stock issued good news and ran substantially higher, then lower in the after hours.  It was relatively unchanged when the stock opened for trading on Friday.  But, if the owners of long calls sold stock short (as a hedge against their calls) when it traded well above 400, they made out well.  Otherwise, option buyers who waited for the market to open on Friday morning took a hit this time.

But it's not always like that.  Recently DNDN (Dendreon) moved from 4ish to more than 20 in a single day when great news was released.  Call owners were handsomely rewarded.

The point is to be careful.  Most of the time it's better to sell premium – with risk limiting strategies – and that means no naked shorts, than to buy.  Not because the stocks don't move, but because the options are too often overpriced.


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No Good Deed Goes Unpunished

I found this post to be so appalling that I had to bring it to the attention of readers of this blog.

Barry provides a great description of how a couple of honest  brokers hurt themselves by taking great care of their customers.  The motto for them is: No good deed goes unpunished.

Another blemish for an industry that doesn't have room for additional blemishes.

Addendum: 2/3/2009 7:40 PM

GMG comments: That's pathetic and very short-sighted. I'm pretty young, so can you tell me, has it always been like this in finance?

There was a time in America (and I assume elsewhere) when people had pride in their work. A time when guarantees and promises meant something. A time when people understood the meaning of having a fiduciary responsibility to the client. I don't understand how or when that disappeared, but it's a rarity these days. And Barry's post illustrates a fine example of people with integrity doing a good job. And they are the ones who were punished. It's very sad.

Over the past few years, risk takers were given greater and greater incentives to seek huge rewards.  Among those with huge incentives where company CEOs.  To earn those gigantic rewards, it's necessary to take huge risk. It's not so easy to have the integrity to keep risk under control, when the personal gains are so large (enough money to last a lifetime). Who can blame them for taking that risk – especially when they had nothing personally to lose (except perhaps a job)?  Not everyone has the integrity to resist.  And last year, those risk takers lost vast sums.

Consider the mortgage brokers who made high commissions by selling loans to people they knew would default. They knew their clients would never be able to make payments – yet they sold the mortgages anyway.

There are plenty of people who make a sale just to get their commissions, knowing that the customer is often shafted. Apparently this is common in today's brokerage world.

Integrity used to mean something to people. I don't know how we became a nation of people who care only for themselves and their cronies. Perhaps integrity can return to this land. I hope so.


Here' the post to which  referred in te opening line.  It's despicable.

By Barry Ritholtz – March 3rd, 2009, 7:09AM

Its fairly well known in the traditional retail investment world that the client and the advisor often have opposing, and sometimes contradictory, interests.

I sometimes forget just how much so in my little world of boutique asset management (We charge about ~1%). A conversation with a couple of brokers from a large firm that I can’t name (hint: Rhymes with Schmerrill) reminded my just how misaligned the incentive system is, and how screwed up it must be to work at a huge, publicly traded, mega asset management firm.

To wit: These two gents run a few $100 million dollars in managed accounts. They are mostly stock jockeys, but they have a smattering of bonds as well. Their assets are spread out amongst stocks they selected, in house managers, and other mangers on their firm’s platform. Typically, the clients are charged 1.0-1.25% on their assets. Various products (I hate that word) will pay the broker more or less depending upon the fund manager’s arrangements with the house.

As is typical of brokers with this size asset base and seniority, their payout was about ~43%.

Let’s do some quick math before we get to the heart of the conflict: On $300 million in assets, let’s call it $3.3 million dollars in gross revenue to the firm. That’s about $1.4 million to them, from which they pay a few sales assistants, T&E, etc. Thus, they each should be making about half million dollars annually before Uncle Sam takes his.

Here’s where things get interesting: Early in 2008, they moved aggressively into cash. (Obviously they are TBP readers). For most of the year, they run about 20% bonds, plus 5% percent stocks (some client would not sell). All told, about 75% of their asset base is in money market funds, which pays out essentially nothing to the broker — but preserves the clients investments. Late in the year, they put a toe back in the water.

Overall, the clients do very well. In a year where the markets are practically cut in half, their clients lose about 10%. The investors are ecstatic, and while the two brokers annual compensation was schmeissed — they went from over $3 million gross to under $1 million — they have happy, referral making clients to rebuild their business upon. Its a short term income hit that should generate gains over the long term. And, they got there by doing the right thing.

Now, that drop in income alone raises conflict issues. I tell clients who ask why they are paying 1% to sit in Cash that they are not — they are paying 1% to not be losing 45% in equities, and to have us tell them when to go back into stocks. We think that’s worth 1%, and if you disagree, well talk to your friends who have seen their investments destroyed.

Here’s where things get completely misaligned. When 2009 rolls around, their manager calls them into his office, and says: “Bad news, boys. Your revenues dropped so much last year you are in the Penalty Box. As per your contract, your payout for this year is 30%.”

Let me make sure I understand this: We did the right thing by our clients, and although we took a big short term revenue hit, we hope it pays off over the long run. And the firm response is to drop our payout even further? So the entire system is set up to discourage doing the right thing by the client?

(Hence, why they are talking with us).

We’ve previously discussed the misaligned compensation system of bankers and the short term incentives that led to the entire credit crisis. But did you have any idea that the entire industry was so utterly conflicted?

I find this utterly ridiculous. No wonder we get so many inquiries from (soon-to-be-former) clients of the big houses:They have been cut in half, but at least the firm got its 1% and the broker’s payout remains at 43%.

And that’s all that matters in the end, right?


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